Larry Holzenthaler, managing director, portfolio manager and senior alternatives strategist at First Eagle Alternative Credit, shared his thoughts on the current state of the private credit market with LCD.
First Eagle Alternative Credit participates in syndicated loans and direct lending, targeting primarily sponsor-backed companies generating annual EBITDA of $10-75 million.
The following interview has been condensed and edited for clarity.
LCD: On the direct lending side of your firm, what would a typical deal you’d do today look like (i.e., spreads, maturity, covenants)?
I think S+500 is probably the new equilibrium in the market. The tightest spread that we’ve committed to is around S+575. We’re seeing leverage anywhere from 3x on the lower end up to 6x on the higher end. Typical terms on our transactions are between 4-6 years.
We typically include either a leverage or cash flow covenant, but a leverage covenant tends to be more of the norm. Our deals often have a 25 or 50 bps step up and step down to the spread based on leverage covenants.
What is your outlook for private credit defaults and recovery rates?
I would not expect default rates to increase dramatically. What you’re more likely to see is a rolling recession scenario, where default rates are higher than average for several quarters sequentially.
Typically, what you see is a spike in defaults, whether it’s global financial crisis or Covid, and then they normalize. Likely what you’re going to see is, instead of a 3% annualized rate that then spikes to 10%, a 3.5-4% default rate that stays higher for three or four quarters. You get to the same place, but you don’t quite see that dramatic risk-off that you tend to see when defaults really spike.
The data that I have seen would suggest that recovery rates in the private market have been slightly lower than the recovery rates in the syndicated market, but this is not a statistically meaningful number.
Can you comment on the trend of private equity sponsors extracting dividends, even from smaller borrower companies?
We are seeing a bit of that, but it’s very case-specific. In certain cases, there are private equity firms that have been very successful on these types of investments, and the business has delivered and improved. Monetizing some of that investment via a dividend, or adding leverage back into the cap structure, makes sense.
You see other deals where you have an aggressive sponsor, who is effectively trying to extract as much money as they can from a transaction that maybe didn’t go according to plan, or has been less successful than people were hoping.
Are we ever going to see a point for private credit where there is a robust, liquid secondaries market?
Not only is it going to happen, but I don’t think it’s necessarily a bad thing for the market. It’s more transparency. People have an option if they don’t like a company anymore, and they want to sell.
But I believe the big direct lending managers are going to push back on that. If I’m running money for, say, big corporate pension funds, I don’t want to have to mark all this stuff to market just because someone sold it at a given level, or just because the syndicated market sold off because Russia invaded Ukraine. Fundamentally, nothing has changed, so I shouldn’t have to mark the price. I do see both sides of the argument.
Do you foresee consolidation among private credit lenders in the near- to mid-future?
I do. There are a lot of new entrants into this market, and credit is an asset class where your experience really matters. Nothing teaches like a good old mistake. I think that there’s likely going to be mistakes that get made, not only for newer entrants to the market, but also people that have scaled very quickly and raised a lot of money very quickly.
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